Choosing between an LLC and S corporation for your enterprise

The Adviser, AllBusiness.com

Published 4:00 am, Wednesday, September 20, 2006

The main difference between Limited Liability Companies (LLCs) and S corporations is the latter carries more extensive corporate formalities. Both entities shield personal assets from company liabilities. Check out the two structures below to decide which would be more appropriate for your company.

S corporations have shareholders and are not taxable like a sole proprietorship or partnership. Income is passed through to the shareholders, who report their pro rata income, or losses, on their individual tax returns. The S corporation shows profits and losses as they pass through to the shareholders, and the corporation generally does not pay federal income tax as a separate entity.

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-- Corporate losses can be passed through to the shareholders and as the owner (and shareholder) you may be able to take the loss against income that appears on your personal return.

-- You can have the protection of limited personal liability without having to pay corporate taxes.

-- You can minimize self-employment tax and FICA tax. Shareholder profits are not taxed in this manner.

Disadvantages include numerous regulations and requirements that must be met, including a limit on the number of shareholders. Like a C corporation, an S corporation can be costly to set up, and you need to follow legal corporate formalities. You will face scrutiny by the IRS of shareholder-employees, who must receive reasonable compensation (subject to employment taxes) before any nonwage distributions may be made to those shareholder-employees.

Like other corporations, S corporations can limit the personal liability of the owners. If there are outstanding debts, creditors can go after the assets of the corporation, but not the owners. It is important, however, that the owners keep their personal financial records and those of the S corporation completely separate to avoid legal entanglements.

An LLC is an alternative to an S corporation. It also limits the liability of its members. LLCs, however, are free of many of the legal requirements that govern corporations (including annual reports, directors meetings, shareholder requirements and so on).

In addition, LLCs are "pass through" tax entities, which means company profits and losses are passed through the business and taxed solely on the members' individual tax returns.

Along with limited liability and the pass-through tax benefit, LLCs also offer other advantages to small-business owners:

-- Members can hire a management group to run the LLC. This group can consist of members, nonmembers or a combination.

-- Members can split profits and losses any way they wish. In corporations, dividends are usually distributed evenly according to the percentages of stock held by each stockholder.

-- Dividend distribution is nontaxable, unlike an S corporation, in which dividends are taxable.

-- An unlimited number of members may join a single LLC, including just a single member.

-- An LLC may affiliate with other businesses. With an S corporation, that ability is limited.

Sit down with both an attorney and an accountant and discuss the details of the business and where you see it in five or 10 years. Cover all the bases including liabilities, taxes, employee benefits and the need for investors before deciding whether to operate as a corporation, LLC or other structure.